ESG Approaches
- Negative Screening (Exclusionary screening) - the practice of excluding certain sectors or companies that deviate from accepted standards in such areas as human rights or environmental concerns.
- Positive Screening (Best-in-Class) - identify companies or sectors that score most favorably with regard to ESG-related risks and/or opportunities
- Thematic Investing - focuses on investing in companies within a specific sector or following a specif theme, such as energy efficiency or climate change
- Impact Investing - seeks to achieve targeted social or environmental objectives along with measurable financial returns through engagement with a company or by direct investment in projects or companies.
Common Equity Risk Factors
- Growth - Growth stocks are generally associated with high-performing companies with an above-average net income growth rate and high P/Es.
- Value - Value stocks are generally associated with mature companies that have stable net incomes or are experiencing a cyclical downturn. Value stocks frequently have low price-to-book and price-to-earnings ratios as well as high dividend yields.
- Size - A tilt toward smaller size involves buying stocks with low float-adjusted market capitalization.
- Yield - Yield is identified as dividend yield relative to other stocks. High dividend-yielding stocks may provide excess returns in low interest rate environments.
- Momentum - Momentum attempts to capture further returns from stocks that have experienced an above-average increase in price during the prior period.
- Quality - Quality stocks might include those with consistent earnings and dividend growth, high cash flow to earnings, and low debt-to-equity ratios.
- VolatilityLow volatility is generally desired by investors seeking to lower their downside risk. Volatility is often measured as the standard deviation of stock returns.
Pros and Cons of ETF
Pros
- Unlike traditional open-end mutual funds, ETF shares can be bought by investors using margin borrowing; moreover, investors can take short positions in an ETF.
- ETFs have smaller taxable events than mutual funds because of the in-kind transfer of securities between an authorized participant and the fund when redemptions occur.
Cons
- Need to buy at the offer and sell at the bid price.
- Paying commissions
- Possibly facing illiquid markets at either purchase or sale.
Discretionary Investment vs. Systematic Investment
Discretionary Investment
- Searches for active returns from firm-specific factors, such as pricing power and the competitive landscape
- Results in more concentrated portfolios reflecting the depth of the manager’s insights on firm characteristics
- Involve managerial judgments on a smaller subset of securities
Systematic Investment
- Is desiged around extracting premiums from a balanced exposure to known, rewarded factors
- Typically incorporates research-based rules across a broad universe of securities.
Contrarian Investing
Contrarian managers invest in stocks with low or negative earnings or low dividends. Contrarians expect the stocks to rebound once the company’s earnings rebound. Contrarian investors often point to behavioral finance research that suggests that investors tend to overweight recent trends and follow the crowd in making investment decisions. Therefore, contrarian investors purchase and sell shares against prevailing market sentiment.
Deep Value Investing
Deep value investing focuses on undervalued companies, which are often in financial distress, that are available at extremely low valuations relative to their assets. The rationale is that market interest in such securities may be limited, which increases the chance of informational inefficiencies.
Restructuring and Distressed Investing
Opportunities in restructuring and distressed investing are generally counter-cyclical relative to the overall economy or a sector’s business cycle. A distressed company that goes through restructuring may still have valuable assets, distribution channels, or patents that make it an attractive acquisition target. The goal of restructuring investing is to gain control or substantial influence over a company in distress at a large discount and then restructure it to restore a large part of its intrinsic value.
Steps in Creating Quantitative Active Strategy
- Define the market opportunity or investment thesis.
- Acquire, process, and transform relevant data into a usable format.
- Back-test the strategy, which involves identifying the factors to include as well as their weights.
- Evaluate the strategy performance using an out-of-sample back-test.
Steps to developing a fundamental active investment process
- Define the investment universe and the market opportunity - the perceived opportunity to earn a positive risk-adjusted return to active investing, net of costs - in accordance with the investment mandate. The market opportunity is also known as the investment thesis.
- Prescreen the investment universe to obtain a manageable set of securities for further, more detailed analysis.
- Understand the industry and business for this screened set by performing industry and competitive analysis and analyzing financial reports
- Forecast company performance, most commonly in terms of cash flows or earnings
- Convert forecasts to valuations and identify ex ante profitable investments
- Construct a portfolio of these investments with the desire risk profile.
- Rebalance the portfolio with buy and sell disciplines.
Ideal Pairs Trade
Two stocks make for an ideal pairs trade if
- the current price ratio differs from its long-term average and shows historical mean reversion, and
- the two stocks’ returns are highly correlated.
Building Blocks of Portfolio Construction
- Alpha Skills
- Position Sizing
- Rewarded Factor Weightings
Well-constructed Portfolio
- Low idiosyncratic (unexplained) risk relative to total risk.
- In comparing portfolios with comparable factor exposures, the portfolio with lower absolute volatility and lower active risk will likely be preferred, assuming similar costs.
- If two products have similar active and absolute risks, the portfolio having a higher active share is preferred.
